THE CIRCULAR FLOW OF THE CIRCULAR FLOW OF ECONOMIC ACTIVITYECONOMIC ACTIVITY

Circular Flow- refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers

fundamental representation of macroeconomic activity among the fundamental representation of macroeconomic activity among the major players in the economy--consumers, producers, government, major players in the economy--consumers, producers, government, and the rest of the world. Different versions of the model and the rest of the world. Different versions of the model sequentially combined the sequentially combined the four sectors-four sectors--household, business, -household, business, government, and foreign--and the government, and foreign--and the three markets-three markets--product, -product, resource, and financial--into increasingly more comprehensive resource, and financial--into increasingly more comprehensive representations of the economy.representations of the economy.

Basic Economic ActivitiesBasic Economic Activities ProductionProduction

• The use of economic resources in the creation of goods and The use of economic resources in the creation of goods and services for the satisfaction of human wants.services for the satisfaction of human wants.

ConsumptionConsumption

• The using up of goods and services by consumer purchasing or The using up of goods and services by consumer purchasing or in the production of other goods.in the production of other goods.

EmploymentEmployment

• The use of economic resources in production; engagement in The use of economic resources in production; engagement in activityactivity

Income GenerationIncome Generation

• The production of maximum amount an individual can spend The production of maximum amount an individual can spend during a period without being any worse off.during a period without being any worse off.

Two Economic UnitsTwo Economic Units

Primary participants in the circular flow Primary participants in the circular flow of goods and servicesof goods and servicesHousehold and FirmsHousehold and Firms

HouseholdHousehold• The basic consuming unit.The basic consuming unit.

This includes everyone, all people, seeking to satisfy This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for unlimited wants and needs. This sector is responsible for consumption and undertakes consumption expenditures. consumption and undertakes consumption expenditures. It also owns all productive resources.It also owns all productive resources.

FirmFirm• The basic producing unit.The basic producing unit. This includes the institutions (especially proprietorships, This includes the institutions (especially proprietorships,

partnerships, and corporations-partnerships, and corporations-BUSINESS BUSINESS ORGANIZATIONSORGANIZATIONS))

that undertake the task of combining that undertake the task of combining resources to produce goods and services. resources to produce goods and services. This sector does the production. It also This sector does the production. It also buys capital goods with investment buys capital goods with investment expenditures.expenditures.

Two Types of Markets in the Circular Flow of Two Types of Markets in the Circular Flow of Goods and ServicesGoods and Services

Resource Resource MarketMarket is where businesses is where businesses purchase what they use to produce goods and purchase what they use to produce goods and services. Resources are in the form of labor, services. Resources are in the form of labor, natural resources, capital, and entrepreneurship, natural resources, capital, and entrepreneurship, all of which are supplied by households.all of which are supplied by households.

Product marketsProduct markets are where goods and are where goods and services are sold.services are sold.

Other Sectors involved in the circular Other Sectors involved in the circular flowflow

Government sectorGovernment sector: : This includes the ruling bodies of the federal, This includes the ruling bodies of the federal,

state, and local governments. Regulation is the prime function of the state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntarily. It buys a portion the other sectors to do what they would not do voluntarily. It buys a portion of domestic product',500,400)">gross domestic product as government of domestic product',500,400)">gross domestic product as government purchases.purchases.

Foreign sectorForeign sector: : This includes everyone and everything This includes everyone and everything (households, businesses, and governments) beyond the (households, businesses, and governments) beyond the boundaries of the domestic economy. It buys exports boundaries of the domestic economy. It buys exports produced by the domestic economy and produces produced by the domestic economy and produces imports purchased by the domestic economy, which are imports purchased by the domestic economy, which are commonly combined into net exports (exports minus commonly combined into net exports (exports minus imports). imports).

Stock and Flow VariablesStock and Flow Variables FlowFlow

• A quantity measured over a particular period of time.A quantity measured over a particular period of time. StockStock

• A quantity measured as of a given point in time.A quantity measured as of a given point in time.

The concepts of stock and flow measurements are essential in The concepts of stock and flow measurements are essential in understanding the economic variables of wealth and income.understanding the economic variables of wealth and income.

WealthWealth• Anything of valued owned. It is a stock since it is what is owned at a Anything of valued owned. It is a stock since it is what is owned at a

particular time.particular time. IncomeIncome

• The rate at which we earn money. It is a flow since income that is The rate at which we earn money. It is a flow since income that is saved, increases the stock of wealth.saved, increases the stock of wealth.

Inflows and OutflowsInflows and Outflows Outflows Outflows (factors that decrease the level of economic activity)(factors that decrease the level of economic activity)

• SavingsSavings• TaxesTaxes• ImportsImports

Inflows Inflows (factors that increase the level of economic activity)(factors that increase the level of economic activity)• InvestmentInvestment• Government SpendingGovernment Spending• ExportsExports

OutflowsOutflows are difficult to control because they are are difficult to control because they are dependent on income. When income increases, we dependent on income. When income increases, we expect savings, taxes, and imports to increase.expect savings, taxes, and imports to increase.

InflowsInflows are easier to manipulate. The proper use of are easier to manipulate. The proper use of policypolicy enables the government to encourage exports and enables the government to encourage exports and investments and to increase its expenditures when it investments and to increase its expenditures when it desires to expand the flow of economic activity.desires to expand the flow of economic activity.

SavingsSavings-is setting aside a portion of a -is setting aside a portion of a person’s income for future useperson’s income for future use

InventoryInventory-normal quantity of goods stored -normal quantity of goods stored by the business firms for future by the business firms for future use(stocks)use(stocks)

InvestmentInvestment-The sacrifice of current -The sacrifice of current benefits or rewards to pursue an activity benefits or rewards to pursue an activity with expectations of greater future benefits with expectations of greater future benefits or rewards. Investment is typically used to or rewards. Investment is typically used to mean the purchase of capital by business mean the purchase of capital by business in anticipation of the profit.in anticipation of the profit.

Taxes-Taxes-Any sort of forced or coerced Any sort of forced or coerced payments to government. The primary payments to government. The primary reason government collects taxes is to get reason government collects taxes is to get the revenue needed to finance public the revenue needed to finance public goods and pay administrative expenses.goods and pay administrative expenses.

Three Sets of PolicyThree Sets of Policy

Monetary policyMonetary policy• Affects the savings and investment.Affects the savings and investment.

Fiscal policyFiscal policy• Controls taxes and government expenditures.Controls taxes and government expenditures.

Trade policyTrade policy• Affects a country’s exports and imports.Affects a country’s exports and imports.

Four Models The Complete Model The circular flow model actually consists of four separate models, each

sequentially adding sectors or markets and thus providing greater complexity and realism.

1. Two Sectors, Two Markets: The simplest circular flow model contains two sectors (household and business) and two markets (product and resource). This model highlights the core circular flow of production, income, and consumption.

2.Two Sectors, Three Markets: A second version of the circular flow model adds the financial markets. This addition illustrates how saving is diverted from the household sector to the business sector to finance investment expenditures.

3. Three Sectors, Three Markets: A third version of the model includes the government sector. This model highlights the importance of taxes, which are also diverted from household sector income and used to finance government purchases.

4. Four Sectors, Three Markets: The most comprehensive circular flow model includes the foreign sector. Adding the foreign sector highlights the role of trade with the rest of the world, especially exports and imports.

The complete circular flow model, with all four macroeconomic sectors (household, business, government and foreign) and all three macroeconomic markets (product, resource, and financial), is presented in the above exhibit.

Economic Model of ProductionEconomic Model of Production

The Circular Flow of the Production ProcessThe Circular Flow of the Production Process

HOUSEHOLDS

ECONOMIC RESOURCES

GOODS AND SERVICES

PRODUCING UNITS

The Circular Flow of Output and IncomeThe Circular Flow of Output and Income

Circular Flow of Physical Goods and Money IncomeCircular Flow of Physical Goods and Money Income

Goods and Services

Factors of Production(land, labor, capital, entrepreneur)

Payments of Factors(rent, wages, interest, profit)

Payment of Purchaseof goods and services.

HouseholdSector

BusinessSector

Circular Flow of Goods Among Production UnitsCircular Flow of Goods Among Production Units

RAW MATERIAL FIRM

CONSUMERS

INTERMEDIATE GOOD FIRM

RAW MATERIALS

FINAL GOODS

INTERMEDIATE

GOODS

FINAL GOOD FIRM

Interrelation BetweenInterrelation BetweenProduction Units & HouseholdsProduction Units & Households

HOUSEHOLDS RESOURCES

RESOURCES

RESOURCES

FINAL GOOD FIRM

INTERMEDIATE GOOD FIRM

RAW MATERIAL FIRM

The Circular Flow of IncomeThe Circular Flow of Income

PURCHASES OF GOODS AND SERVICES

INCOME FLOW OF WAGES, INTERESTS, RENTS

HOUSEHOLDSPRODUCING

UNITS( FIRMS)

Circular Flow of Income Among Production UnitsCircular Flow of Income Among Production Units

FINAL GOOD FIRM

RAW MATERIALS FIRM

MONEY PAYMENTS FOR INTERMEDIATE GOODS

MONEY PAYMENTS FOR RAW MATERIALS

INTERMEDIATE GOOD FIRM

HOUSEHOLDSMONEY PAYMENTS FOR FINAL

GOODS

Economic Model of Income and ConsumptionEconomic Model of Income and ConsumptionThe Circular Flow of Goods and IncomeThe Circular Flow of Goods and Income

Among Producers & HouseholdsAmong Producers & Households

HOUSEHOLDS INTERMEDIATE GOOD FIRM

RAW MATERIAL FIRM

MONEY PAYMENT FOR PURCHASE OF FINAL GOODS

RESOURCES

MONEY PAYMENT FOR RESOURCES

RESOURCES

MONEY PAYMENT FOR RESOURCES

RESOURCES

MONEY PAYMENT FOR RERESOURCES

FINAL GOODSFINAL GOOD FIRM

The Circular Flow ofThe Circular Flow ofGoods & Income of Households & FirmsGoods & Income of Households & Firms

with the Government & Foreign Countrieswith the Government & Foreign Countries

GOVERNMENT

HOUSEHOLDS PRODUCING UNITS

FOREIGN COUNTRIES

Income Payments of Wages, Rent,Dividends, & Interests

Purchase of Goods & Services

Economic Resources

Taxes Taxes

Wages, Transfer Payments Purchase of Goods& Services

Goods & Services

Money Payments forImports

Money Payments forExports

The Circular Flow of The Circular Flow of Economic Activity Economic Activity Reflecting The Outflows & The InflowsReflecting The Outflows & The Inflows

HOUSEHOLDS PRODUCING UNITS

Income Payments of Wages, Rent,Dividends, & Interests

Purchase of Goods & Services

Economic Resources

Goods & Services

IMPORTS

TAXES

SAVINGS

EXPORTS

EXPENDITURES

INVESTMENTS

Foreign Countries

Government

Banks

Implications of the Implications of the Circular Flow of Economic ActivityCircular Flow of Economic Activity

1.1. The goods, resources, and money payments will flow as long The goods, resources, and money payments will flow as long as households continue to consume, and as long as firms as households continue to consume, and as long as firms continue to produce.continue to produce.

2.2. That since goods and resources flow in exchange for That since goods and resources flow in exchange for payments, the rate of payments flow will in the end be the payments, the rate of payments flow will in the end be the same. Money is the inducing factor, and the pillar of the price same. Money is the inducing factor, and the pillar of the price system. Without it, there is no price system.system. Without it, there is no price system.

- THE END -- THE END -

GOOD DAY!!! GOOD DAY!!!